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January 01, 2011 at 07:00 PM
Time may not heal all wounds. As the equity market continues adding to gains from its March 2009 nadir, individual investors still favor fixed income investments. According to the Investment Company Institute, October 2010 marked the seventh consecutive month of outflows for stock funds. Determined not to take losses that left them emotionally distraught, investors seem to prefer missing the rally to risking a stock market pullback. And though some have finally started committing small allocations back to stocks after September and October’s huge gains, the flow is more a trickle than a flood.
This reluctance puts advisors in a jam. Clients cannot achieve their financial goals unless they take risk. At the same time, they must have the ability to stick with positions that experience short-term volatility in order to benefit from long-term economic growth.
Welcome to the post-credit crunch New World. Although markets are rife with investment opportunities, headlines proclaiming currency wars, partisan bickering, and sovereign debt defaults will likely dominate the cerebral real estate of many clients.
In the following pages, we will explore the best places to allocate capital—and a few ways to get clients to re-embrace investing—after experiencing the twin equity market debacles of the last decade.
60/40 Burnout
Typically, advisors start the asset allocation process by determining a client’s risk tolerance. This is achieved via a third party questionnaire or similar risk assessment. Results are then fed into software that determines the best portfolio mix for each level of volatility.
Thus explains the origin of the popular blend of 60% stocks and 40% bonds. Having only historical correlation and return data to work with, allocation software will naturally default to portfolios that have done well over the long haul. But it’s hard to believe that the next decade will resemble the prior 10 years.
Today’s advisors are certainly following some unusual asset class behavior. Equities were trounced by bonds in the 2000s. Anyone investing during that period using asset return data from the prior 10 years—a period of unusually robust equity returns—would have suffered. Clearly, there is more to the asset allocation decision than buying high and selling low.
There are ways to structure a portfolio that constrain the process to a lesser degree. Instead of using 60-40 (or another ratio) as the defining allocation to stocks and bonds, it should be thought of instead as a combination of return generating and diversifying investments. This makes both intuitive and pragmatic sense. Investors realize that stocks have more return variability, and over sufficiently long periods will probably generate higher returns than bonds. But there will be occasions when fixed income-oriented investments have enough return potential to be included in the first category.
[Read about three simple rules for investing.]
Take foreign denominated sovereign debt, for example. If accessed through a leveraged closed-end fund, this asset class has much greater volatility than most other bond investments—and certainly has enough upside potential to be a return generator.
Similarly, investments in utility stocks plod about like other income-oriented positions, which should put them squarely in the latter bucket.
The attraction of this risk “bucketing” method cannot be understated. Clients find comfort in knowing that the asset management approach being employed reflects the rapid changes in the markets. At the same time, advisors using this approach are not hamstrung by the traditional definitions of equity and fixed income.
What really makes risk bucketing work is the advisor’s ability to select investments for each category. Examining ways that different asset classes work together is an important first step.
A Change in Leadership
Any conversation about equities as an asset class must be done in the context of their return relative to their compatriot, fixed income.
Since stocks and bonds lie on opposite sides of the capital structure, what is beneficial for one is commonly detrimental to another. This is especially true during transition periods. Research has shown that bondholders of firms can suffer losses in a takeover, particularly if the takeover is largely funded with debt, resulting in more negative correlation between a company’s stock and bond returns.
Now consider the relationship at the asset class level. During periods of economic growth, stocks and bonds are usually slightly positively correlated. The two assets classes also tend to fall together during periods of rising interest rates, due to the negative impact of higher rates on earnings growth and the drop in the real value of coupon payments.
The circumstances that make stocks and bonds decouple from one another are far more interesting. The so-called “flight to quality” environment, where investors flee risky assets for the safety of fixed income, is one example. The credit crunch of 2008 is a case in point. With stocks being mercilessly pounded during that year’s fourth quarter, long-term government debt had a field day.
The other low-correlation scenario is during periods of low inflation and minimal economic growth. Suppose an investor wanted to wager that inflation (and economic growth) would be near zero going forward. What’s the best way to do this? By purchasing bonds. With muted inflation, the coupon payments from a bond would not lose any of their purchasing power. And if this low growth scenario came to light, it would most probably occur in tandem with low interest rates, which would cause the bond to appreciate in value.
The no-growth, low-inflation mantra typically results in lower correlations between stocks and bonds, a scenario that is occurring now. Besides affecting returns, investors’ predilection toward bonds has also driven the correlation between equity and fixed income lower.
Curiously, periods of low correlation are often associated with changes in leadership among these two asset classes. For example, the low correlation in January 1999 was followed by the tech meltdown and lower rates, which buoyed bond prices. The end of 2003 saw this reverse, and widened credit spreads brought about by the Enron and WorldCom collapses gave way to higher equity prices. Correlations were also low during much of 2008, but bounced well before stocks rebounded in the second quarter of 2009.
Correlation changes are but one reason to believe that equity markets might outpace bond returns in the coming year. Thanks to cost cutting, corporate profits have now surged above where they were in 2007. And in most cases, companies are “banking” this profit in the form of cash on their balance sheets. The current love affair with yield has made corporate borrowing (in the form of bond issues) another important source of cash for firms looking to get more liquid while the getting’s good.
So what’s to become of all this cash? In many cases—especially the large cap technology sector—firms are buying start-ups instead of investing directly in research and development. A better use for that coin may be dividends payments. This could bring income-oriented investors—a group that had no previous interest in technology stocks—into the fray.
